Sunday, March 26, 2017

Somalia has long played host to one of the world's strangest monetary phenomenon, a paper currency without a central bank. I explored the idea of Somalia's "orphaned currency" more fully four years ago, but if you're in a rush what follows is the tl;dr version. Despite the fact that both the Central Bank of Somalia and the national government ceased to exist when a civil war broke out in 1991, Somali shilling banknotes continued to be used as money by Somalis. Over the years, Somalis also accepted a steady stream of counterfeits that circulated in concert with the old official currency, a state of affairs that William Luther explores in some detail here.

The story is worth revisiting because apparently Somalia's newly restored central bank is on the verge of re-entering the game of printing banknotes after a quarter century absence. With the help of the IMF, the Central Bank of Somalia (CBS) plans to issue new 1000 shilling banknotes, the introduction of higher denomination notes coming later down the road.

Old legitimate 1000 shilling notes and newer counterfeit 1000 notes are worth about 4 U.S. cents each. Both types of shillings are fungible—or, put differently, they are accepted interchangeably in trade, despite the fact that it is easy to tell fakes apart from genuine notes. This is an odd thing for non-Somalis to get our heads around since for most of us, an obvious counterfeit is pretty much worthless. The exchange rate between dollars and Somali shillings is a floating one that is determined by the cost of printing new fake 1000 notes. For instance, if a would-be counterfeiter can find a currency printer, say in Switzerland, that will produce a decent knock off and ship it to Somalia for 2.5 U.S. cents each (which includes the cost of paper and ink), then notes will flood into Somalia until their purchasing power falls from 4 to 2.5 U.S. cents... at which point counterfeiting is no longer profitable and the price level stabilizes.

Below is the long-term price of Somali shillings, which I've snipped from Luther's paper. You can see how the purchasing power of a 1000 shilling note has fallen to what Luther calculates to be the cost of producing a new banknote, around 4 cents. His chart goes up to 2013, but if you look at the IMF's most recent report on Somalia (see Figure 3) you'll see that the exchange rate hasn't moved much.

So with a new official banknotes on the way, what will happen to the old legacy notes and counterfeits? According to the IMF mission chief Mohammed Elhage, the IMF is in the midst of trying to determine at what price it will convert old notes for new official ones. So rather than repudiating counterfeits, the normal route taken by central bankers, the CBS will buy them up and cancel them. It will have to offer a decent price too, say like 5 or 6 U.S. cents for each 1000 note. If it makes a stink bid, say 3 U.S. cents, Somalis may simply ignore the appeal to bring in their old currency and keep using the old stuff. Because the buyback decision validates the work of counterfeiters, it just seems wrong. However, keep in mind that for the last twenty-five years it has been counterfeiters who have been willing to take on the risk of providing Somalis with a very real service, the provision of a working paper medium of exchange.

There is another good reason for buying up old legacy notes and counterfeits and cancelling them. If the CBS lets the old notes stay in circulation, then Somalia's ragtag multi-currency system will only get more confusing, with old legacy and counterfeit notes circulating concurrently with new shillings and U.S. dollars. With the new issue of shillings having a different purchasing power than the old ones, yet another floating exchange rate will be added to the mix. Who needs that sort of confusion? Better for the CBS to absorb the cost of buying up fakes in order to promote a more homogeneous currency.

***

As I pointed out in my old post, there's an old and nagging question in monetary economics that has never been satisfactorily answered: why is fiat money valuable? Somalia serves as a great laboratory to investigate this question because its situation is so unique. One famous answer to the riddle of fiat money is that governments use force to ensure that fiat money is valued. But this can't be the case in Somalia: it hasn't had a government since 1991, yet shillings continue to be accepted.

A second answer is that once money is valued—say because it a central bank has been pegged to an existing store of value like gold—then once the central bank disappears and the anchor is lost, those orphaned notes will continue to have value by dint of pure inertia and custom. This theory certainly seems to fit Somalia's experience.

The last theory is that when a central bank is destroyed, the money it issues will quickly become worthless... unless citizens expect a future central bank to emerge and reclaim the orphaned currency as its own. If so, it makes sense to keep using the currency since it isn't actually orphaned—it's on the way to being adopted. If the expectation is that this future central bank will also adopt counterfeit notes, it makes sense for people to accept all knock-offs as well. So we can tell a story that shillings, both real and fake, never fell to zero because enough Somalis had a hunch that a future body would reclaim them, a hunch that is on the verge of being realized as a newly-christened CBS seems set to buy old and fake shillings back. Were Somalis really this good at predicting the future? I don't know, but like the second theory, the last one seems to explain the data.

***

Personally, I think introducing a new paper currency is a bad idea. For some time now Somalia has been partially dollarized economy. U.S. dollar banknotes are the most popular paper currency, with old shillings being used in small payments and in the countryside. Mobile payments are extremely popular, but they are usually denominated in U.S. dollars, not shillings, and tend to be prevalent in cities where network coverage is best.

There are several problems with dual-currency systems like Somalia's. First, they impose a small but steady stream of currency conversion costs on the population, both the actual cost of shifting one's wealth from one to the other as well as the mental gymnastics involved in converting prices in one's head. Secondly, there are fairness issues. Civil servants are usually paid in the domestic currency and those in rural parts deal in the stuff. Urban private sector workers tend to earn dollars. In developing nations, dollars are usually more stable than domestic currency. As a result prices of houses, cars, and rent are often set in dollars. The class of folks who are paid in dollars make out better than the class that is earning shillings. Dollar earners never have to leave the much stabler dollar loop while those earning domestic currency suffer from constant slippage due to conversion costs and chronic inflation.

Now the IMF might argue that new shillings will completely expel dollars, thus forcing everyone into the same shilling loop and removing any monetary inequalities. But that's hog wash. The literature on dollarization teaches us that once the dollar begins to be used by a country—usually because the domestic currency has suffered from high inflation—it is very hard to remove it. Long after the local currency has been successfully stabilized, dollarization continues, an effect referred to by economists as hysteresis. Bring back the shilling and the dollar will stick around.

While bringing back new shillings doesn't make much sense, some sort of currency reform is probably worthwhile. While cities seem to be already well-served by dollars and mobile money, the rural population still relies on old and deteriorating shilling notes. Instead of foisting new shillings on these people, why not replace them with locally-minted small denomination dollar coins? I call this the Panama solution. For those who don't know, Panama is a dollarized nation. Due to the high costs of shipping in coins form the U.S., Panama mints its own dollar-denominated small change, paper money printed by the Federal Reserve taking care of the rest of the nation's physical money requirements.

By adopting the Panama model all Somalis would get to deal in U.S. dollars, thus removing any monetary class divisions. Gone too would be the headache of constantly converting between shillings and dollars, since with U.S. coinage there would only be dollars. And poor Somalians living in rural areas without phone coverage would finally get clean and homogenous small denomination cash.

Admittedly, there's far less for a central banker to do if he/she issues a narrow range of small denomination U.S. denominated coins, say 1¢, 5¢, and 25¢, rather than a full range of banknotes. It's certainly not sexy. But it would be cost effective. Coins, after all, last much longer than notes. This
durability means that coins are a cheaper circulating medium for a
central bank to maintain than paper. There is also the national ego that must be satisfied. What nation doesn't have its own currency? The worst reason to adopt a new shilling is because some concept of nationhood requires it—Panama has been using the dollar for decades, and this hasn't prevented it from becoming one of Central America's most successful nations.

Wednesday, March 15, 2017

R3, a company specializing in distributed ledger technology, has just posted a paper I wrote for them entitled Fedcoin: A Central Bank-issued Cryptocurrency. And here is a nice write-up on the Fedcoin idea in American Banker, which unfortunately is behind their paywall.

The paper is pretty wide-ranging, but one thing that's worth focusing on is the ability of Fedcoin to provide some of the same features as banknotes, in particular anonymity and censorship resistance. That a Fedcoin system can be designed to provide the same degree of privacy as cash runs counter to some of its early critics, who see in Fedcoin a coming financial panopticon.

One really neat things about good ol' cash is that, like bitcoin, it is a decentralized network. The opposite of this is a centralized network, say something like the deposit banking system. In the banking system, storage of value is handled by the issuing bank through accounts hosted on the bank's database. Conversely, in a banknote system, the issuing central bank offloads the task of storing value onto us. We the public—think of us as nodes in a decentralized network—are responsible for choosing how and where to keep our cash, say in a wallet, or under our bed, or in a safety deposit box, as well as bearing those storage costs. The central bank doesn't care how we manage this task, though they'd prefer that we don't mangle the notes too much.

Or take the process of securely transferring value. Centralized actors like banks handle all the stages of moving deposits from a buyer to a seller, including verifying identities, ensuring adequate account balances, updating ledger entries etc. But in a transfer of banknotes, the transaction process is entirely devolved to the buyer and seller, who must physically move the cash to the right location, count out by hand the necessary quantity of banknotes, and then come to a consensus that the transaction has been settled. As for the central bank's ledger of notes, there is nothing that needs updating. Unlike private bankers, central bankers don't care who owns their circulating liabilities.

The task of screening for counterfeit notes is also outsourced to the public. Each time a shopper accepts a banknote, say as change, they'll give it a once-over to verify that it hasn't been run off by a teenager using an inkjet printer. Retailers deal in cash all day and are familiar with banknote anti-counterfeiting devices, and thus can exercise more judgement in checking for fakes. And banks, the recipient of notes from retailers at the end of the day, will catch many of the counterfeits that have slipped through the system.

Banknote systems aren't entirely decentralized, of course. The central bank has the final say on whether a note is counterfeit or not. It also regulates the purchasing power of those banknotes, either by toggling interest rates higher or lower, repurchasing money using its portfolio of assets, or issuing more money in return for assets.

Because they are at least partly decentralized, banknote systems inherit two nice features: anonymity and censorship resistance. The first feature is self-explanatory: the central issuer makes no effort to determine the identity of a banknote owner. Proceeding from this, the issuer lacks enough information to censor, or prevent any particular party, from using the banknote network. These are completely open systems. By contrast, centralized systems like banks can easily censor members of the public from making payments. Take the Huntingdon Live Sciences episode in 2001, for instance, in which a UK-based company involved in drug-testing was cut off by British banks in response to pressure from animal rights activists. Other examples of censorship by banks include the blockade of Wikileaks and the monetary embargo of Iran.

Now in theory a banknote system could be modified by introducing more centralization, thus removing anonymity and introducing censorship. Each banknote has a unique serial number. The central bank could set a rule that for every cash transaction, the buyer and seller are obligated to log in to a government-provided account where they register the note's serial number into a tracking database. To get these accounts, users would be required to submit documents and ID. This would destroy the anonymity of cash users and open the door for censorship. In practice, though, the guardians of banknote systems have chosen to preserve anonymity by ignoring serial numbers.

One of the major trends over the last decades has been dematerialization, the replacement of paper by bits and bytes as a medium for holding data. This saves on costs like printing, storage, and distribution; improves speed; and reduces waste. We saw it with stock & bond certificates a few decades ago, books, newspapers, music, record keeping, bills. And one day we may see it with cash. The question is: how to allow for the dematerialization of cash without losing its useful features like anonymity and censorship resistance?.

Bitcoin is one answer. But Bitcoin only goes half-way to solving the problem since it does not recreate one of cash's other key features, its stability. A nation's prices are conveniently denominated in terms of its paper money (i.e. U.S. retailers set prices in dollars, Japanese retailers in yen), and since prices tend to stay sticky for 4.3 months or so on average, the public has a huge degree of certainty over the medium-term purchasing power of the money in their wallets. This is a very nice feature. Bitcoin prices? Not so stable.

Fedcoin may be able to recreate this stability while still providing anonymity and censorship resistance. A government copies the source code of a proven cryptocoin (maybe bitcoin, maybe zcash, maybe ethereum), boots the system up, and promises to peg the price of each coin to its existing banknotes, say 1 coin = $1 banknote.

As with bitcoins, anyone would be able to hold Fedcoins without the necessity of providing identification. And like Bitcoin, Fedcoin could be designed in such a way that a distributed collection of Fedcoin nodes (or miners) validate transactions by referring to the system's shared history. Remember how the Fed allows banknote users to anonymously come to a consensus about the validity of a banknote transactions i.e. they do not have to log in to an account to register note serial numbers? Likewise, Fedcoin could be designed in a way that nodes have the ability to remain anonymous. This would preserve a degree of censorship resistance and openness. After all, if validators must unveil themselves, governments and other powerful actors might compel those nodes to censor transactions.

This is just one way of setting up anonymous central bank money. I'm sure there are many others. There are also ways to set up non-anonymous central bank money, but these are less interesting to me, a point I made here. As I point out in the R3 paper, I think my preferred set-up would be to allow individuals a rationed amount of anonymity, targeting some sort of “sweet spot” such that there is enough anonymity-providing exchange media for regular consumers but not enough for criminals. But I can't wrap my head around how to design something like this. Anyways, go read the paper, there's plenty more.

PS: I also recently had an article on bitcoin published in the Common Reader, a publication of Washington University in St. Louis.

And since we're on the theme, I should link to some other public appearances by yours truly, including recent-ish podcasts with David Beckworth and Alex Millar.

Wednesday, March 8, 2017

David Andolfatto and Larry White have been having an interesting debate on the public finance case for having a large (or small) Federal Reserve balance sheet. In this post I'll make the case that American taxpayers are better off having a large Fed balance sheet, perhaps not as big as it is now, but certainly larger than in 2008.

To explain why, we're going to have to go into more detail on some central banky stuff.

The chart below illustrates the growth of the Fed's balance sheet. Prior to the 2008 credit crisis, the Fed owned around $900 billion worth of assets (green line), these being funded on the liability side by $800 billion worth of banknotes (red line), a slender $10-15 billion layer of reserves (blue line), and a hodgepodge of other liabilities. The Fed now owns an impressive $4.5 trillion in assets. These are funded by around $1.5 trillion worth of banknotes and $2.3 trillion worth of reserves. So the lion's share of the increase in the Fed's assets is linked to the expansion in reserves, which have ballooned by around 25,000%.

There's a problem with the above chart. It shows reserves clocking in at just $10 billion prior to 2008, but it's important to keep in mind that this *understates* the quantity of reserves issued by the Fed. Prior to 2008, the Fed would typically lend out tens of billions worth of reserves to banks during the course of the day, these amounts being paid back before evening. These loans are referred to as "daylight overdrafts." Because the above chart uses end-of-day data, it omits daylight overdrafts, thus making the balance sheet look smaller than it actually was.

How big did the Fed's balance sheet actually get during the course of a day thanks to overdrafts? Prior to the 2008 credit crisis, daylight overdrafts typically peaked at around $150 billion. So if we recreate the chart using intraday Fed data, the pre-2008 balance sheet would be around $800 billion + $150 billion, or 20% larger than if we use end-of-day data. And rather than a relatively flat pattern, we see a pulsing pattern. I've drawn out the chart by hand to give a sense for how the balance sheet would have looked, although its not to scale and doesn't use real data.

So why does the Fed offer daylight overdrafts? One of the business lines in which a commercial bank participates is the processing of payments on behalf of its clients to other banks, these recipient banks in turn crediting sent funds to their clients. To make these interbank payments, banks use deposit accounts at the central bank, or reserves.

In the U.S., legally-stipulated reserve requirements force banks to hold small quantities of central bank reserves overnight. So when the U.S. banking system opens in the morning for business, a bank will typically already have some funds in their reserve accounts that can be used to make client payments. However, the ability of this small layer of required reserves to carry out the nation's payments will soon be swamped—after all, the quantity of transactions conducted on a single day using reserves is massive, currently clocking in at $3 trillion.

In theory, banks might choose to hold an excess quantity of reserves overnight (i.e. more than the legally mandated minimum) in preparation for the next day's payment cycle. However, the Fed has historically kept the overnight interest rate on reserves at 0%, far below the market overnight interest rate. So no bank wants to hold reserve overnight if they can avoid it. If they did, their profits would suffer.

To ensure that banks have the ability to carry out the nation's business come morning, the Fed has typically provided the necessary reserves via daylight overdrafts. When the banks close for business in the evening, the Fed then sucks the reserves it has lent to banks back in. Alex Tabarrok once fittingly described banks as inhaling credit during the day, "puffing up like a bullfrog" —only to exhale at night.

As I mentioned earlier, before the credit crisis hit Fed-granted daylight overdrafts used to rise as high as $150 billion over the course of the day. Since 2008, the quantity of daylight overdrafts has declined quite dramatically. See the chart below:

Why have banks stopped applying for overdrafts? In 2008 the Fed began to pay interest to any bank that held reserves overnight. Rather than "exhaling at night," it suddenly made sense for banks to hold reserves till the next morning. This new demand for overnight balances was not met by daylight overdrafts, which must be paid back by the end of the day. Rather, a new permanent supply of reserves began to emerge thanks to the Fed's policy of quantitative easing. Under QE, the Fed created reserves and spent them to purchase bonds, these reserves staying outstanding as long as the Fed did not repurchase them, potentially for decades. The upshot is that banks are now quite happy to hold huge amounts of Fed-issued reserves on a permanent basis. As such, they no longer need to make use of daylight overdrafts to carry out the nation's payments.

So let's bring the conversation back to the taxpayer. As you should hopefully see by now, the debate between keeping a big balance sheet and returning to its pre-2008 size is closely intertwined with the following question: do we want our central bank to provide daylight overdrafts or not? Because if we are to go back to 2008—i.e. to a period when overnight reserves were "scarce," as Larry White describes it—then by definition we are advocating daylight overdrafts.

I'd argue that taxpayers might prefer that the Fed not provide daylight overdrafts. To begin with there is the question of credit risk. If a bank that has been granted an overdraft were to fail during the course of business, the Fed would be out of pocket. Since the central bank is ultimately owned by the taxpayer, that means taxpayers could take a big hit when a bank fails.

The Fed could protect itself by requiring banks provide collateral as security for access to Fed overdrafts. Now when the offending bank goes under, the Fed has a compensatory asset in its possession that it can use to make good on the loan, thus sparing the taxpayer. However, the protection afforded the Fed by collateralized daylight overdrafts comes at the expense of the nation's deposit insurance scheme, the Federal Deposit Insurance Corporation, or FDIC. To ensure that depositors of a failed bank are made whole, FDIC typically sells off the bank's assets. If the Fed has taken one of those assets for itself as collateral for a daylight overdraft, FDIC will have one less bank asset at its disposal and may have to dip into taxpayer funds to make up the difference. The overall risk faced by the taxpayer has not been reduced.

By maintaining the status quo—i.e. a large quantity of reserves—the taxpayer gets more protection from bank failures. Banks must buy reserves, or tokens, ahead of time to ensure that they can meet the payments needs of their clients. So the Fed acts as a seller, not a creditor, and therefore does not expose taxpayers to risk of bank failures. At the same time, FDIC does not face the prospect of having risk shifted onto it should the Fed seize collateral from a failed bank with unpaid daylight overdrafts.

Now the preceding discussion might seem to tilt me towards David Andolfatto's position of keeping a large balance sheet, albeit for different reasons than him. Not entirely. While a large quantity of reserves will be sufficient to insulate the taxpayer from bank failures, it needn't be as large as the current $2.5 trillion in outstanding reserves. As I pointed out earlier, prior to the 2008 credit crisis the Fed would typically grant around $150 billion in daylight overdrafts. This was sufficient to facilitate ~$2.7 trillion in payments (see data here). So each dollar in reserves was able to support 18x that value in payments. The Fed currently processes around $3.1 trillion in payments, a task that could probably be discharged with ~$200 billion in daylight overdrafts, assuming that the 18x ratio still prevails. So as long as the Fed were to keep at least $200 billion of the $2.5 trillion in reserves outstanding, that amount should be sufficient to replace the need for daylight overdrafts.